The Risks of Chasing Yield: Balancing Income and Safety in Your Portfolio

By Matt Kelley, Chief Investment Officer, ESL Investment Services

Am I reaching for too much yield?

At its core, investing is putting assets to work to fund future liabilities, whether the timing, amount and/or variance are known or unknown. When liabilities become known and constant (ex. living expenses in retirement), investors may want to see income or positive yields from their portfolio. However, generating income from your portfolio and your portfolio producing income can be two entirely different things. Often, when investors need to produce income from their portfolios they may start to migrate towards securities and investments that pay out income in the form of higher dividends and/or interest payments without considering the risks involved.

The facade that yield is equal to quality

To be clear, earning income from your portfolio is not a bad thing, however, the mindset of “more is better” is where investors can get in trouble. A higher yield is often associated as being superior, after all, don’t we want to generate more money from our investments? Unfortunately, this question sometimes ignores what is happening to the prices of the underlying investments.

For example, the dividend yield of a company’s stock is calculated by dividing the dividend payment by the price of the stock. This means the yield can go up because the dividend payment increased, however, the yield can also go up because the price of the stock is falling.

Ironically, if a company is facing financial strain resulting in difficulty paying a dividend, a declining stock price and increasing dividend yield might be a precursor to a dividend cut. Historically, 25% of companies in the highest dividend yield quintile have cut their dividends over a three-year period.¹

Consider the risks of volatility

Companies that pay out most of their earnings as a dividend leave less room for weathering an economic downturn (in the event earnings fall) or for other capital allocation opportunities such as reinvesting in the company or buying back shares. It’s important to evaluate the quality of the dividend yield of portfolio companies before investing. One possible metric to observe would be the payout ratio, the ratio between the dividend and the earnings of the companies. A smaller payout ratio can indicate more ability to sustain the dividend, all else equal. Additionally, growth of the dividend throughout time can indicate management’s commitment to both maintain and grow the dividend.

Avoid overlooking diversification for yields

Many investors also invest in fixed income, or bonds, in order to diversify their portfolios. Attention should be paid to yields here as coupons, or interest payments, are an important component of fixed income investing. Again, investors can get into trouble when reaching for more yield, as lower-quality companies tend to pay higher interest rates. A higher interest rate is not necessarily a bad thing; however, it can also ignore the effect on portfolio diversification. For example, high yield bonds (below investment grade) are much more correlated to equities, on average, than investment grade bonds, as lower-quality companies tend to be more affected by economic downturns. Meaning both portfolio components could likely fall at the same time. As a result, a higher yielding fixed income portfolio may not provide the same diversification benefit as a high-quality fixed income portfolio.

Calculating total return

There is no rule in investing that says an investor can only spend the income produced by the portfolio. In fact, a more prudent approach could be investing the portfolio to maximize total return within an investor’s risk constraints. Total return is the combination of both income and capital appreciation (the increase in price of the underlying securities). Some investors might be concerned that spending in excess of the income produced by the portfolio will erode principal. This may be the case, however, the alternative could be worse. As mentioned above, if reaching for the yield necessary to meet spending requirements sacrifices capital appreciation, an investor is already unintentionally affecting principal.

Of course, the tax effects of income and capital appreciation are important considerations. If securities are held in a taxable portfolio, income is taxed when it is received, meaning it can actually be less tax efficient as it creates less flexibility for the investor to manage after-tax returns. Capital appreciation is taxed when the securities are sold and can give the investor the flexibility of where and when to take taxable gains. There are a lot of moving parts here, including different tax rates for capital gains and income, different tax brackets for the investor, as well different type of accounts the investments are held (taxable, retirement, etc.). Additionally, some securities (ex. municipal bonds) may have income that is exempt from some taxation. Investors may want to consider working with a financial planner to navigate the tax landscape and focus on after-tax returns.

Final thoughts

In summary, if the primary goal of investing is to put your assets to work to fund your future liabilities and spending needs, be sure to look at the fuller picture than just yields. While income is an important part of a portfolio’s return, reaching for more income can potentially affect a portfolio’s total return and diversification negatively. Maximizing a portfolio’s after-tax total returns within an investor’s risk constraints can aim to maximize the investor’s ability to meet their investment objectives.

1: (Danke Wang, CFA, FRM, Portfolio Manager, 2024).

Matt Kelley is Chief Investment Officer, ESL Investment Services. In his role, Matt is responsible for institutional account portfolio management and oversees the portfolio strategy team, while supporting the broader organization.

No strategy assures success or protects against loss.

The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.

Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.